What You Need to Know About Partial 1031 Exchanges

When it comes to 1031 exchanges, it’s a common misconception that you must reinvest all sale proceeds to qualify for tax deferral. In reality, a partial 1031 exchange lets you reinvest a portion of your gains and still defer taxes on that amount.

In this article, we’ll explain how partial exchanges work, how the IRS treats unreinvested funds not reinvested and when this approach might make sense for your investment goals.

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What Is a Partial 1031 Exchange?

A partial 1031 exchange occurs when you reinvest only part of the proceeds from your relinquished property into a like-kind replacement rather than the full amount. In doing so, you still receive the benefits of tax deferral on the reinvested portion, while paying capital gains taxes only on the amount you don’t reinvest.

The portion of the sale proceeds you retain is referred to as  “boot,” which can come in the form of cash, mortgage relief (when your replacement property has less debt than the relinquished property) or other non-like-kind benefits received in the exchange. This amount is taxable, but it doesn’t disqualify the entire exchange.

Here’s an example:

You sell a commercial building for $2 million. You reinvest $1.6 million in a like-kind property and keep $400,000.

The $1.6 million qualifies for tax deferral under Section 1031. The $400,000 retained is considered boot and will be subject to capital gains taxes.

For many investors, this approach is the best of both worlds because it enables them to tap into some liquidity while still deferring a large portion of your tax liability.

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When Does a Partial Exchange Make Sense?

1. You Want to Access Some Cash

Sometimes, full reinvestment isn’t the goal or even necessary. If you want to set aside funds for a new business venture, a personal investment or a large expense like tuition or home renovations, a partial exchange lets you keep some of your sale proceeds. The boot will be subject to capital gains tax, but the remainder of your transaction will still qualify for tax deferral under Section 1031 as long as it’s structured correctly. This gives you liquidity without sacrificing all the benefits of an exchange.

2. The Replacement Property Costs Less Than the Relinquished Property

It’s not always about trading up. If the right investment opportunity presents itself at a lower price point, you shouldn’t feel locked into a full-value reinvestment just to satisfy a 1031 exchange. In this case, the difference between your sale price and the cost of the replacement property will be taxed, but the rest of the transaction remains eligible for deferral. A partial exchange gives you the freedom to make decisions based on investment value, not just price.

3. You’re Looking to Reduce Debt

Partial exchanges also make sense for investors who want to lower their financial exposure. If you’re carrying a large mortgage on the relinquished property, acquiring a replacement property with less (or no) debt can help you lower debt service requirements and improve property cash flow. Just be aware that mortgage relief is also considered boot and will trigger some taxable gain. Still, for many commercial investors, the tradeoff of accruing less debt in exchange for partial tax deferral is worth it in the long run.

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What Are the Tax Implications of a Partial 1031 Exchange?

While Section 1031 allows for the deferral of capital gains taxes on the reinvested amount, the IRS will assess taxes on any non-like-kind property or cash you receive, including mortgage relief. This taxable amount is generally calculated as the difference between your relinquished property's value and what you actually reinvest. 

Here’s how it breaks down:

• Cash Boot: Any proceeds you receive at closing or choose not to reinvest will be treated as cash boot and taxed as capital gains.
• Mortgage Boot: If your new property carries less debt than your old one, the difference in liability may also be taxed, even if you don’t physically receive any cash.
• Combined Boot: In some cases, you may have both types, which the IRS will evaluate together when determining your taxable gain.

Back to our earlier example. Let’s say you sell your property for $2 million, but only reinvest $1.6 million. That $400,000 difference will be taxed — whether in cash, debt relief or both. However, the $1.6 million that was properly reinvested remains protected under the 1031 exchange rules.

It’s important to note that this doesn’t mean you’ll lose the benefits of the exchange altogether. Partial exchanges still allow you to defer taxes on the majority of your gain, making them a smart solution for investors seeking both flexibility and efficiency.

Working with a knowledgeable Qualified Intermediary (QI) and tax advisor will ensure the correct reporting of your boot and help you plan for the tax consequences so there are no surprises come tax season.

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How to Make the Most of a Partial 1031 Exchange

A partial 1031 exchange can open up new strategic possibilities, but it also comes with some complexity. Planning ahead and approaching the process with intention and efficiency is critical for the exchange to be structured properly and deliver the benefits you’re counting on.

Here are a few key ways to get the most value out of a partial exchange:

1. Start with your goals. Maybe you're looking to increase cash flow, rebalance your portfolio or free up capital for a new investment or business venture. Whatever your objective, it should guide how much you reinvest and how much you retain. Partial exchanges work best when they align with a broader investment strategy — not just a short-term tax decision.
2. Work closely with a QI. Be upfront with your QI about your goals and timeline so they can help structure the exchange accordingly. In a partial exchange, they’ll help document which portion of the proceeds is reinvested, calculate boot and ensure the transaction complies with IRS guidelines. 
3. Know your tax exposure. The amount of boot you take affects your immediate tax liability. Understanding how the IRS will treat cash and mortgage relief ensures you’re not caught off guard. Consult with a tax advisor early in the process so they can confirm whether a partial exchange makes sense for your situation.
4. Be strategic about property selection. Choosing the right replacement property matters even more in a partial exchange. You may be investing in a lower-cost asset or one with less debt, but it should still meet your long-term performance goals. If possible, identify multiple properties or explore options that align with your risk tolerance and overall financial strategy.

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Talk to a 1031 Expert About Your Options

National 1031 helps commercial investors make the most of every exchange opportunity. Wondering if a partial exchange is right for you? Contact us to connect with a 1031 expert and get the answers you need to move forward with certainty.

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